California faces deadline tomorrow to avoid junk bond status

The state of California must pass a budget by tomorrow or its credit rating could tumble to junk status. Both Moody's and Standard & Poor's have warned the state of a multinotch downgrade if the state fails to approve a budget.
California currently has an A2 rating, the lowest of any state. Governor Arnold Schwarzenegger needs to close a $24.3 billion budget deficit and has threatened to cut essential services if a budget agreement cannot be reached.

On Wednesday, July 1, California Controller John Chiang will begin to pay bills with IOUs because he will run out of cash if the legislature doesn't deal with the deficit for the coming fiscal year. Fitch Ratings downgraded California's general obligations Friday to single-A-minus from single-A, citing "the magnitude of the state's financial and institutional challenges and persistent economic and revenue weakening."

George Friedlander, Morgan Stanley Smith Barney muni analyst, warned that while he can't conceive of an outright default on California municipal bonds, he recommends "some diversification out-of-state" for holders of the state's paper. He added that a disorderly disruption of California's finances could spread beyond munis, affecting all risk assets and the dollar. Investors are nervous and after what they went through last year, could sell first and ask questions later.

The California legislature is deadlocked over the state's budget. Democrats want to raise taxes, while Republicans want to cut entitlement spending. The state's budget deficit for 2010 is expected to be 20 percent of its general fund budget or more than $20 billion. As California's bond rating drops, the harder it will be for the state to finance public works projects because it will become prohibitively more expensive to do so.

The state's bond rating is not the only one at risk. The California State Teachers' Retirement System, the second-largest U.S. public pension, may face a lower credit rating as well. S&P told the pension system its credit rating could be cut.

S&P's rating criteria limits a pension fund rating to be no more than three levels higher than the general obligation creditworthiness of the governmental sponsor of the pension fund. As a result, if California's A rating were lowered, the teachers' pension fund's AA rating would also fall, S&P said in a statement.

Lita Epstein has written more than 25 books including Reading Financial Reports for Dummies.